New Deal Moves Moscow Closer to Being a Global Financial Center

In a world starved for yield, Russian government local-currency bonds look like an interesting investment. Yields on 10-year OFZs, as Kremlin treasury obligations are known, are near 8 percent -- a richer return than Spain or Italy from a borrower with a much less troubled balance sheet. The payment currency, Russia’s ruble, has its ups and downs but has been on a tear lately, gaining more than 5 percent against the dollar over the past three months.

But the hassles of investing in a Russian-registered security (as opposed to Eurobonds or equities traded in London) have largely kept international capital out of the domestic bond market. Among other problems, Russian law does not allow for nominal shareholdings by foreigners; they have to open a local brokerage account and let the broker keep custody of their securities. Settlement practices are also shaky.

“Foreign investors are not very excited about dealing with local bond market infrastructure,” concludes Nikolai Podguzov, head of fixed-income research at VTB Capital in Moscow. Just 5 percent of the $100 billion OFZ market is in non-Russian hands today, he estimates.

But the rules of the Russian bond game should soon change markedly for the better. On Oct. 4, Russia’s Federal Financial Markets Service approved a tie-up between Moscow’s National Settlement Depository (NSD) and both Euroclear and Clearstream, the two big players in resolving custody for global investors in far-flung emerging markets.

The FFMS approved the link tentatively and with conditions, the most important being that the NSD complete its merger with long-time rival Depository Clearing Company, giving Russia a unified shareholding and bondholding system for the first time. But market pros like Maria Ivanova, head of depository at Deutsche Bank in Moscow, predict it will be finalized by the end of this year.

Russia offers quasi-sovereign bonds from state corporations like Vnesheconombank and Federal Grid Company that pay some 150 basis points higher interest than sovereigns with little more default risk, Podguzov points out. But liquidity is more limited, so investors will likely get their feet wet with OFZs. If the FFSM is satisfied with bond trading via Euroclear and Clearstream, it has said it will open the gates to equities in mid-2014.

The ruble bond market’s new window on the West is part of a broader story: Russia’s oft-derided but creeping progress toward its government’s proclaimed goal of “turning Moscow into an international financial center.” The Kremlin convened a blue-ribbon panel to this end in 2010 chaired by President Vladimir Putin’s former chief of staff Alexander Voloshin, and a series of steps since then cleared the way for Euroclear and Clearstream.

Voloshin started by nudging Russia’s two competing stock exchanges, Moscow International Currency Exchange and Russian Trading System, to merge, which they did under MICEX’s banner in late 2011. A unified exchange made possible the unified depository that traders had called for in vain for more than a decade. This in turn was a precondition for linking to the outside world on custody and settlement issues.

The shape of the agreement with Euroclear and Clearstream also reveals divisions within Russia on internationalizing securities markets, Ivanova notes. Russia’s central bank and finance ministry pushed for the global alliances. Local brokers complained that the international agencies could put them out of business and leave too much of Russia’s financial fate in foreign hands.

“If this goes through, our securities market will work by the principle of outsourcing,” Oleg Vyugin, a respected former head of the FFSM who is now chairman of private-sector bank MDM, warned Russian news agencies this summer.

The debate ended in a compromise that should open the ruble bond market to global investors starting in early 2013, while regulators get another 18 months to decide on equities Euroclear/Clearstream access to equities.

Russia’s national depository means to push forward with modernization in the interim, says NSD chairman Eddie Astanin. His next big project is a central counterparty (CCP) mechanism of the type that international regulators have recommended to stave off a future Lehman Brothers-style market meltdown. Russia already has a CCP for on-exchange currency trading, and looks to deploy a prototype for equities and derivatives next year.

For investors, this tinkering with Russia’s financial plumbing should mean access to one promising new instrument, sovereign bonds in rubles, and the hope of systemic improvement in what should be one of the developing world’s leading securities markets. “The move toward a financial center is sometimes not taken seriously even on the local side,” Deutsche Bank’s Ivanova says. “But it is gradually making local markets look more civilized.”